Bears talk of market crash, but they are largely full of hot air

With US markets hitting all-time highs, bearish observers are warning that another market crash – the third in the past 14 years – may be imminent.

Is it? Anything is possible, so who knows. It’s certainly easy to make a case that US markets, in particular, are richly valued.

However, while some bearish arguments have merit, others are founded on little more than hot air. Here are eight commonly cited warnings that simply do not stack up.

Margin debt

“Nothing has been learnt from the madness of the 1929 stock market crash as once again traders reach for record amounts of debt to pile into rising share prices,” ran a recent

Telegraph

piece. “Traders are now more exposed to a fall in share prices than at the height of the dot-com bubble at the turn of the century, and just before the financial crisis during the 2007 peak.”

There is a superficial plausibility to this argument that masks its utter irrelevance.

Yes, margin debt (money borrowed to buy stocks) is near all-time highs, just as it was in 2000 and 2007. However, margin debt is a coincident market indicator, not a leading one.

A certain number of investors will always use margin to boost returns. As the market capitalisation of the stock market rises, the margin debt figure must also rise with it. That’s why more than a quarter of all monthly margin debt readings since 1980 have been at record levels.

Accordingly, unless margin debt suddenly explodes higher, bearish hyperbole on the subject is best ignored.

QE is ending

Since 2009, the US Federal Reserve has pumped trillions of dollars into financial markets, its programme of quantitative easing (QE), encouraging investors to “gobble up” risky assets, according to Société Générale bear

Albert Edwards

. Bears such as Edwards see the five-year rally as one fuelled by QE; with QE nearing an end, stocks will inevitably be hit hard, they say.

There’s no doubt that quantitative easing has juiced returns. However, bears often make the mistake of saying this has been a market solely driven by the Fed.

Two points. One, indices almost invariably enjoy outsized returns in the years following market crashes. Secondly, S&P 500 earnings per share are forecast to hit $120 this year. That’s almost triple the low of $43 registered in March 2009, and mirrors the 200 per cent return seen in the overall stock market.

Those who insist the market is driven only by QE, market strategist Barry Ritholtz said recently, are ignoring typical post-crash behaviour as well as the recovery in earnings, and "are not doing yourselves any favours".

Cape fear?

Nobel economist

Robert Shiller

recently cautioned that the S&P 500’s cyclically adjusted price-earnings ratio (Cape) has only been exceeded on three occasions. Each time – in 1929, 2000 and 2007 – this was followed by a market crash.

Cape has its detractors, but few deny it has been a valuable signpost in the past. No doom-monger, Shiller’s caution is noteworthy.

However, as Shiller himself often points out, a high Cape reading doesn’t mean a crash is necessarily imminent.

High readings point to poor long-term returns, but tell you nothing about where stocks will be in 12 months. Stocks may not ever fall – they might stagnate for years, with rising earnings gradually lowering the Cape reading.

Finally, Cape advocates such as Shiller and investment manager Mebane Faber don't recommend that investors view high Cape readings as a reason to go to cash. Rather, they suggest that investors rotate into cheaper assets. Many emerging market and European indices trade on relatively low Cape ratios, for example, and Shiller recently cited the value to be found in UK equities.

Technology valuations

Many warn of a technology bubble, and it’s easy to cite the seemingly insane valuations of various social media stocks. That doesn’t mean the overall market is a bubble.

In fact, it doesn’t even mean the technology sector is bubbly. The Nasdaq 100 trades on 21 times earnings, compared with more than 100 in 2000.

In 2000 as well, the tech sector accounted for 33 per cent of the market capitalisation of the S&P 500, up from 13 per cent in 1998. Today, it accounts for 19 per cent – almost unchanged since the bull market began in 2009. So madness in a few social media stocks does not a market bubble make.

Vix warning

The Vix, or fear index, is around 12 today – well below its historical average and the lowest level since 2007, before the global crash. This indicates that markets are dangerously complacent, bears warn.

However, while high Vix readings can help discern market bottoms, low Vix readings don’t suggest market tops. Low Vix readings usually last for years, as they did between 1992 and 1996, and again between 2004 and 2007. In fact, 12-month returns tend to be better following low readings.

The Vix has closed below 13 on more than 1,000 days over its 24-year history. Almost all, as Bill Luby of the Vix and More blog has noted, have come in the middle of a bull market.

Ordinary investors are exuberant

Ordinary investors have a deserved reputation for being lousy market- timers, so it’s deeply worrying that equity allocations are near six-year highs. Right?

Well, equity allocations are at 67 per cent, the 17th consecutive month in which they have been above their historical average of 60 per cent. Cash allocations are at their third-lowest level since March 2000.

However, this can be seen as a logical response to a low-yielding world rather than irrational exuberance. Sentiment surveys have continually reflected a cautious outlook, indicating that retail investors are reluctant bulls. Finally, equity allocations hit the 70 per cent level many times between 2004 and 2007, while today’s weightings are nowhere near the 77 per cent peak registered in early 2000.

Consequently, it’s hard to see the current readings as a red flag.

It’s time

More than five years old, the US bull market has lasted almost twice as long as the average cyclical rally. Furthermore, it’s been more than three years since stocks suffered a double-digit correction.

That doesn’t mean a crash is around the corner. The current rally is the fourth-longest of the last century, well behind the 13-year bull run (a bear market is defined as a 20 per cent decline) between 1987 and 2000.

As for corrections, stocks didn’t suffer one double-digit decline between 1990 and 1997.

The current run is a long one, but also something of a technicality. Stocks briefly fell 9.9 per cent in 2012, and by 19.4 per cent in late 2011. Take these dates into consideration, and the current bull market looks decidedly less aged.

It’s autumn

This “tends to be a volatile period for stock markets”, to borrow once more from the

Telegraph

. “The stock market crashes of 1929, 1987, 2001 and 2008 all happened in September and October”.

However, markets didn’t collapse in September 2008 because traders consulted Mystic Meg. They fell as a reaction to the collapse of Lehman Brothers. Similarly, the falls in September 2001 were a consequence of the 9/11 attacks. Besides, the dotcom crash actually began 18 months earlier, in March 2000.

In other words, this is astrological nonsense, mistaking a minor coincidence for something more sinister.